Unit 1: Introduction to Finance, Financial Statements, and Financial Analysis
Finance is a broad subject, and financial decisions are all around us. Whether you work on Wall Street or in a small company, finance is vital to every business. Therefore, understanding the fundamentals of finance is vital to your business education. This introductory unit addresses fundamental concepts of finance, stocks, and bonds. Also, Unit 1 exposes the importance of understanding ratios for financial statement analysis and analysis of cash flows. The main ratios explained are: solvency (or liquidity ratios), financial ratios, profitability ratios, and market value ratios. In addition, you will learn about financial growth, what financial factors determine growth, the importance of maintaining a sustainable growth rate, and how to use financial statement information to manage growth. Consider this situation: You are the manager of a small retail chain and your boss has given you the task of deciding whether to invest in a second store. You know that adding a second store means greater potential for growth. However, you also know that adding a new store will require spending cash. Facing this tough decision, how could you determine whether the company can "handle" such an investment? The answer might lie in ratio analysis. This section will explain how to use financial ratios to help you make these types of business decisions.
Completing this unit should take you approximately 25 hours.
Upon successful completion of this unit, you will be able to:
- explain the primary goal of financial management;
- describe how stocks and bonds function and their effect on corporate structure;
- explain how financial managers use the income statement, the balance sheet, and the statement of cash flows to make better informed decisions;
- compute the major financial ratios in order to evaluate a company's performance;
- analyze pro-forma financial statements in order to evaluate the future performance of a company; and
prepare an analysis of a company's financial statements.
1.1: Introduction to Concepts in Finance
1.1.1: Ethics
We begin this course with an examination of the ethical considerations involved in finance. You will want to read carefully so that you can differentiate between ethics and morals. Be sure you can explain why it is important for individuals working in the financial sector to keep organizational, professional, and personal ethical behavior front-and-center.
1.1.2: Financial Decisions: Investment and Financing
As you read, ask yourself, "What criteria do corporations use to make financial decisions?". Investments and financing decisions boil down to how to spend money and how to borrow money. Two fundamental types of financial decisions are discussed in this section. First, investment involves capital assets that will provide the highest return over a specified time period. Second, financing refers to using own money or raising capital from external funding sources. By the end of this reading, you will be able to identify the criteria a corporation must use when making a financial decision.
1.1.3: Bonds
- The cost of money is the opportunity cost of holding money instead of investing it, depending on the interest rate. An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. Market interest rates are mostly driven by inflationary expectations, alternative investments, risk of investment, and liquidity preference. Term structure of interest rates describes how interest rates change over time.
- A yield curve shows the relation between interest rate levels (or cost of borrowing) and the time to maturity. It also tells what investors' expectations for interest rates are and whether they believe the economy is going to be expanding or contracting. Three variables determine interest rates: inflation rate, GDP growth, and the real interest rate.
Par value is the amount of money a holder will get back once a bond matures; a bond can be sold at par, at premium, or discount. The coupon rate is the amount of interest that the bondholder will receive per payment, expressed as a percentage of the par value. Maturity date refers to the final payment date of a loan or other financial instrument. A callable bond allows the issuer to redeem the bond before the maturity date; this is likely to happen when interest rates go down. A sinking fund is a method by which an organization sets aside money to retire debts. Other important features of bonds include the yield, market price, and putability of a bond.
Bonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and a variety of term structures. However, bonds are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
- A bond is an instrument of indebtedness of the bond issuer to the holders. Duration is the weighted average of the times until fixed cash flows of a financial asset are received. A bond indenture is a legal contract issued to lenders that defines commitments and responsibilities of the seller and buyer. Bond credit rating agencies assess and report the credit worthiness of a corporation's or government's debt issues.
- A government bond is a bond issued by a national government denominated in the country's domestic currency. A zero-coupon bond is a bond with no coupon payments, bought at a price lower than its face value, with the face value repaid at the time of maturity. Floating rate bonds are bonds that have a variable coupon equal to a money market reference rate (e.g., LIBOR), plus a quoted spread. Other bonds include register vs. bearer bonds, convertible bonds, exchangeable bonds, asset-backed securities, and foreign currency bonds.
- Most individuals purchase bonds via a broker or through bond funds. By the end of this reading, you will be able to describe the process for purchasing a bond and explain why bond markets may not have price transparency.
- The value of a bond is obtained by discounting the bond's expected cash flows to the present using an appropriate discount rate. Yield to maturity is the discount rate at which the sum of all future cash flows from the bond are equal to the price of the bond. "Time to maturity" refers to the length of time before the par value of a bond must be returned to the bondholder. This reading will show you how to calculate a bond's yield to maturity and calculate the price of a bond.
Bondholders face several types of risk, including price risk, reinvestment risk, and default risk, among others. A bond's credit rating is a financial indicator assigned by credit rating agencies; bond ratings below BBB-/Baa are considered junk bonds.
1.1.4: Stock Valuation
- The stock of a company represents the original capital paid into the business by its founders and can be purchased in the form of shares. Shareholders have the right of preemption, meaning they have the first chance at buying newly issued shares of stock before the general public. By the end of this reading, you will be able to explain what it means to own stock and describe some of the rights of shareholders.
- By the end of this reading you will be able to define common stock and preferred stock and differentiate between these two types of stock.
This reading explains the rights of shareholders, depending on what kind of stock they own, including the right to claim income in the case of bankruptcy, voting rights, right to buy newly created shares, etc. This reading further differentiates preferred stock and common stock.
The actors in the stock market include individual retail investors, mutual funds, banks, insurance companies, hedge funds, and corporations. The world's largest stock exchange market is the New York Stock Exchange (NYSE), and the NASDAQ is an American dealer-based stock market in which dealers sell electronically to investors or firms. By the end of this reading you will be able to differentiate among these stock markets and explain the purpose and function of a market index.
- Valuations rely heavily on the expected growth rate of a company; past growth rate of sales and income provide insight into future growth. A no-growth company would be expected to return high dividends under traditional finance theory. The portion of the earnings not paid to investors is, ideally, left for investment in order to provide for future earnings growth. By the end of this reading you will be able to explain how a stock is valued and describe the limitations of valuing a company with dividends that have a non-constant growth rate.
- Three approaches are commonly used in corporation valuation: the income approach, the asset-based approach, and the market approach. This reading will help you be able to differentiate between these three models.
1.1.5: Institutions, Markets, and Intermediaries
This section discusses the financial intermediary as an institution that facilitates the flow of funds between individuals or other economic entities. By the end of this reading, you will be able to discuss the purpose and types of financial institutions and identify the role that financial intermediaries play in the economy.
1.1.6: Securities
This reading will introduce the types of stock market transactions, including IPOs, secondary market offerings, private placement, and stock repurchase. By the end of this reading, you will be able to differentiate between the different types of market organizations which facilitate trading securities: auction market, brokered market, and dealer market.
This reading will help you define and distinguish realized returns from unrealized returns. By the end of this reading, you will be able to calculate an investment's dollar return and percentage return. You will also be able to describe how historical and average returns can be used to predict future performance.
This reading explains why transparent financial markets provide efficient information about financial instruments, and aid in the discovery of financial information by interested parties. There are three ways to categorize markets based on the types of information available in the market. After reading this you will be able to identify all three market conditions, which are called "efficiencies". When markets provide the most efficient form of readily available information, no one party can benefit unfairly from the price changes in a market.
- This section discusses some of the most important legislation meant to regulate finance and protect stakeholders.
1.2: Corporate Finance and Corporate Structures
The first of the following videos explains the definition of a stock and what individual investors obtain when they buy a share of a company's stock. The next video explains the definition of a bond and what individual investors obtain when they buy a corporate bond. The final video explains the difference between a stock and a bond.
1.2.1: Corporate Finance
This section discusses how a corporate bond is issued by a corporation to rise money in order to expand its business. Key takeaways from this discussion include the definition of a corporate bond, secured loan/debt, unsecured loan/debt, senior debt, and subordinated debt. By the end of this reading, you will be able to explain how an organization can finance their operations through bonds.
Convertible securities are convertible bonds or preferred stocks that pay regular interest and can be converted into shares of common stock. By the end of this reading, you will be able to identify the different features of convertible bonds and discuss the advantages and disadvantages of convertible bonds.
- Options give the owner the right, but not the obligation, to buy or sell an underlying asset or instrument. By the end of this reading, you will be able to describe the different factors that influence the value of an option and differentiate between the types of options.
- A warrant is a security that entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date.
- A derivative is a financial instrument whose value is based on one or more underlying assets. By the end of this reading, you will be able to identify the uses of derivatives and differentiate between the different types of derivatives.
Derivatives allow risk related to the price of underlying assets, such as commodities, to be transferred from one party to another.
1.2.2: Liability of Principal and Agent
As you read this chapter, consider why contracts are important and how they work. Pay close attention to the following topics: liability in contract, principal criminal liability, and how agency relationships are terminated. By the end of this reading, you will be able to name the principal's liability in contracts, torts, and criminal law and the agent's personal liability in tort and contract, and how agency relationships are terminated. The relevance of legal issues presented in this section is integrally connected with business finance and how relationships are conducted in the business world.
1.2.3: Equity Finance
This section discusses how companies can use equity financing to raise capital, and/or increase shareholder liquidity (through an Initial Public Offering-IPO). By the end of this reading you will be able to explain the process of financing a firm through equity capital. For the aspiring business executive or student, it is critical to understand and be able to apply how businesses raise equity capital to expand their operations.
1.3: Financial Statements
This video introduces balance sheets. A balance sheet statement is an account of the value of assets, liabilities, and net worth of a company. It is always considered during a point in time, such as December 31, 2011. Assets are things that a company owns; whereas liabilities are things that a company owes. Assets minus liabilities results in the net worth of a company.
This video introduces balance sheets and equity.
This video introduces income statements. An income statement is an account of the revenues (net sales), costs, expenses, and taxes of a company during a period of time, say from December 31, 2011 to December 31, 2012. The goal of an income statement is to compute the net profits of a company and all the different items involved.
This video introduces cash accounting. An accountant, who is responsible for preparing financial statements, is concerned with accrual basis accounting; whereas, the financial analyst or manager is concerned with cash-basis accounting by keeping track of the real uses and sources of cash. Make sure you understand this difference.
This video introduces the accrual basis of accounting.
This video compares accrual and cash accounting.
This video discusses the relationship between balance sheets and income statements.
This video introduces cash flow statements.
1.3.1: Financial Statements, Taxes, and Cash Flow
- Read this lesson, which covers defines the financial statement, and covers uses and limitations of financial statements.
- Read this lesson, which focuses on the elements and limitations of the income statement, as well as the effects of GAAP on the income statement. Noncash items will also be discussed.
- This lesson will give you an introduction to the balance sheet, a representation of a firm's financial position at a single point in time. The balance sheet is one of the four major financial statements. You will be able to identify assets, liability, and shareholder's equity, and learn how to compute the balance sheet equation. You will also be able to create a balance sheet.
- This lesson exposes you to the impact of taxes on firms. You will learn how different forms of corporate organization affect the tax obligations for the firm and the individual owners. You will be able to compute tax liability, using the tax rate. This section defines the various types of taxes, and discusses the impact of depreciation on taxable income. It also compares a tax credit with a tax deduction, and demonstrates multiple methods of computing depreciation.
- This section gives an introduction to the "Statement of Cash Flows", which is one of the major financial statements. You will be able list the three types of cash flows and their connection to other financial statements. You will also learn how to interpret the Statement of Cash Flows.
- In this section you will learn about less commonly used financial statements such as the Statement of Equity and the Free Cash Flow Statement (which is different from The Statement of Cash Flows), and their uses in finance. It also explains the difference between economic value and market value.
1.3.2: Analyzing Financial Statements
- This section provides more insight into the standard elements that are included in all balance sheets and income statements. It provides a listing of common accounts on each statement and the order in which those accounts are listed.
- This section provides a general overview of what a financial ratio is, how they are used, and the relevant categories of financial ratios.
- After reading this section, you will have been exposed to the different types of profitability ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- After reading this section, you will have been exposed to the different types of asset management ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- After reading this section, you will have been exposed to the different types of liquidity ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- After reading this section, you will have been exposed to the different types of debt management ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- After reading this section, you will have been exposed to the different types of market value ratios, their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- As you read this section, you will learn about some special ratios that address dividend growth, return on assets and equity. You will be exposed to their formulas, how to compute them, and which financial statements contain the information needed to calculate the ratios. You will read about the DuPont Equation (also known as the strategic profit model), which is comprised of multiple financial ratios. You will also learn how to interpret the ratios and apply those interpretations to understanding the firm's activities.
- An overview of how financial ratios are used to aid in company analysis is presented in this lesson. Financial ratios are used for industry comparisons, benchmarking, and trend analysis. This section also presents some limitations of financial ratio analysis to consider when evaluating firms.
- This lesson describes what inflation is and the various categories of inflation. I discusses the impact that inflation in an economy has on a firm's earnings and financial statements.
- This section mentions other items that can distort the true value or representation of information on financial statements. It provides information about two primary examples of distortions: accounting errors and unusual one-time gains or losses.
1.3.3: Forecasting Financial Statements
- After reading this section you will understand how to create a forecast of the income statement, using assumptions for the future growth of expenses and sales by category. A forecasted financial statement is called a "pro forma" statement. You will be able to distinguish between levels of profit on the income statement and classify activities as operating or non-operating activities.Pro Forma financial statements are useful for valuing a firm in preparation for its sale, for comparisons of the impacts of financial proposed transactions, or for estimating future costs and expenses under certain business scenarios.
- After reading this section you will understand how to create a forecast of a balance sheet. A forecasted financial statement is called a "pro forma" statement. You will be able to distinguish between accounts on the balance sheet, and better understand how to analyze a pro forma balance sheet. Pro Forma financial statements are useful for valuing a firm in preparation for its sale, for comparisons of the impacts of financial proposed transactions, or for estimating future costs and expenses under certain business scenarios.
- This section emphasizes the importance of cash and good cash management to a business. You will learn how to analyze cash inflows and outflows so that you can better forecast a firm's cash budget. When you have completed this section, you will be able to describe the direct and indirect method of cash flow forecasting. Cash flow is often used a determinant providing financing to firms. A cash budget is used along with pro forma financial statements to assess the impact of financial transactions.
- When you have completed this section, you will be able to use ratio analysis to assess a firm's performance to compare its performance to itself, its competitors, its industry, and across time. You will learn the categories of ratios, how to compute ratios and how to interpret the numeric values of a ratio as a comment on the firm's performance. Ratio analysis is used when considering the impact of certain financial transactions affecting a firm.
1.3.4: The Statement of Cash Flows
- This section exposes you to one of the four major financial statements, the "Statement of Cash Flows". It explains how to create and interpret the statement, as well as discusses the three major activities that produce cash for a firm: operating, investing, and financing.
1.4: Financial Ratios
This video discusses how to compute the P/E ratio and its significance.
An overview of the financial ratios is presented in this section. The manager or student may well ask the question "Why are financial ratios important to understanding the activities of the business?". This question is addressed in this section. Pay particular attention to the following topics: (1) Sources of financial ratios, (2) Purpose and types of ratios, (3) Accounting methods and principles, (4) Abbreviations and terminology, and (5) A summary of all ratios used to analyze financial statements. Try to commit to memory some of the basic formulas presented in this section.
This section presents financial ratios and their analysis. Why are financial ratios and their analysis important? To answer this question, you should pay particular attention to the firm's profitability, and allow comparisons between the firm and its industry. By the end of this reading, you will be able to summarize how an interested party would use financial ratios to analyze a company's financial statement.
Five key concepts are presented in this section. They are: (1) evaluating financial statements , (2) Industry comparisons, (3) Benchmarking, (4) Trend Analysis, and (5) Limitations of financial statements. Read this entire section because explanation is given how financial ratios are evaluated, compared, and benchmarked. These financial tools are used widely in the banking and credit industry to evaluate businesses that apply for credit. The banking decision to grant credit to a business is based on whether or not the analysis of the ratios demonstrates that the organization can repay the loan that they are requesting from the bank.
1.5: Pro Forma Financial Statements
Read this section that discusses the Pro Forma income statement. Pay close attention to the definition of Pro Forma statement because it is planned and prepared in advance of a transaction to project the future status of the company. By the end of this reading, you will be able to draft a pro forma income statement. Businesses in all industries use Pro Forma income statements to make managerial decisions that affect their sustainability.
This section discusses the Pro Forma balance sheet. The question concerning "Why should the Pro Forma Balance Sheet be used in a business?" is relevant as the economy changes. Possible uses of the Pro Forma balance sheet include mergers and acquisitions, warranties and negotiating a commercial lending relationship to support growth. A pro forma balance sheet summarizes the projected future status of a company after a planned transaction, based on the current financial statements. By the end of this reading, you will be able to prepare a pro forma balance sheet.
Read this section and pay close attention to the summary of pro- forma financial statements as follows: (1) the pro-forma income statement, (2) the pro-forma balance sheet, (3) assessment of pro-forma statements, (4) the bigger picture, and (5) end of chapter problems. Attempt the practical exercises at the end of the section to check your understanding about the uses of pro-forma financial statements. Note that the images in this resource are broken. Per the publisher's website, the resource is in draft mode.
This section discusses financial modeling and pro forma analysis. The five key takeaways include: (1) Introduction - financial goals and long-term planning, (2) Percent of sales method, (3) Forecasting a planned expansion, (4) The planned expansions value, and (5) Growth and firm value. Managers and executives use these financial tools regularly to make internal decisions and to present to external partners such as banks and investors.
Unit 1 Assessment
Take this assessment to see how well you understood this unit.
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